The Death of Small-Cap Stocks: RIP 2012

Trying to pick small-time winners is a fool’s errand right now

Nobody feels the pain on Wall Street these days quite like the little guy.

A fairly common indicator of how “healthy” the stock market is involves the performance of smaller companies vs. their blue-chip brethren. And if you’re watching that metric right now, it’s clear that the stock market is hacking and wheezing.

Click to Enlarge Just check out the underperformance of the benchmark Russell 2000 index vs. the Dow Jones Industrial and S&P 500 as the market cooled and the financial crisis came home to roost.

Though blue chips peaked in 2007, the underperformance of the small-cap index before that was a warning sign — and the meltdown in 2008 shows smaller stocks taking a more severe beating then larger corporations.

Click to Enlarge Fast forward to present day: Small-caps peaked in May 2011 after a rebound rally from 2009 lows and are back to their sickly ways of underperformance. The Russell 2000 is barely flat as of this writing compared with 5% gains in the S&P 500 and Dow Jones across the past 13 months or so.

It looks like an ugly situation for small caps. And from what some are saying, it’s about to get worse before it gets better.

Bigger Might Not Be Better, But It’s Safer

The flight out of small caps is logical when you consider the Wall Street landscape. Here are the three big reasons folks are looking away from the little guys:

Risk: Investors are avoiding risk like the plague. When a meager 1.5% yield on 10-year T-Notes is “good enough” for many portfolios — and others trust Treasuries so little they are in cash — that tells you everything you need to know. The inherent risk in a smaller stock without scale or a safety net has scared off many investors, even from good small-cap companies.

Stability: Blue chips can get pummeled too, as the meltdown of 2008 showed us. But a certain class of large-cap stocks are undoubtedly stable — staples stocks like Kraft (NYSE:KFT) have strong baseline demand, public utilities like Duke Energy (NYSE:DUK) are legalized monopolies and telecoms like AT&T (NYSE:T) aren’t going anywhere thanks to the ubiquity of smartphones and the Internet. Why chase an up-and-comer in a challenging economic environment when you can have an entrenched giant that will weather the storm?

Yield: Throw in the fact that Kraft yields 3% — twice the 10-year Treasury bond — while utilities are north of 4% and telecoms are north of 5% and you can understand the attraction. Small-caps in growth mode, however, are plowing their cash into their business instead of dividend payments.

So are big stocks “better?” Hardly. There are a number of small-caps that have outperformed nicely in the last few months — and some of these picks will have bright futures. But the fact remains that many small-caps will suffer more severely in the short-term amid market volatility and macroeconomic challenges.